How to Spot Overpriced Investments

By Jim Walker on Monday, October 1st, 2018 |
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The S&P 500 has been on a steady upward climb for the last nine and a half years. As the market climbs higher and higher the smart investor needs to know how to spot overpriced investments. Ideally, one has bought low at the beginning of the bull market and can sell high before the market or individual stocks correct. The S&P 500 index is four times greater than it was in February of 2009. However, this year the vast majority of gains within the S&P 500 group have come from a handful of well-known tech stocks. CNBC noted that just three stocks are responsible for most of the gains in 2018.

Amazon, Netflix and Microsoft together this year are responsible for 71 percent of S&P 500 returns and for 78 percent of Nasdaq 100 returns.

The three stocks make up 35 percent, 21 percent and 15 percent of S&P 500 returns, respectively, while making up 41 percent, 21 percent and 15 percent of Nasdaq 100 returns.

While some companies in the S&P 500 are simply appreciating less rapidly than the tech darlings, others are losing ground. The best performers are those with the best and reliable earnings quarter after quarter. The question for the wary investor is how to spot overpriced investments in this mix. In this regard, Market Watch says that the average stock is overvalued.

The offer three charts, all of which demonstrate that the market is flirting with the sort of valuations that preceded the 1929 crash that ushered in the Great Depression, the Dot Com crash, and the 2008 crash that gave us the Financial Crisis and the Great Recession.

The three charts show three things. First, the market is trading about 70% above its historic mean and this has only happened before in the days preceding a crash. Second, the total stock market cap compared to the US GDP is also at a historic high seen only in the days prior to previous market crashes. And, third, the prices of stocks are excessive in relation to the so-called “replacement” value of the companies. This is the Tobin Q ratio. In order to avoid being badly hurt when the market eventually corrects, smart investors can use any or all of these approaches to decide what investments to hold and which to sell.

Margin of Safety

We mentioned that the leading stocks in the S&P 500 are there because of continued great earnings. But, which of these companies is vulnerable to a significant reduction in earnings in the event of a recession. And, which of them has a margin of safety to protect them in the event of a downturn. A margin of safety can be money in the bank or tangle assets like property and factories that are unencumbered by debt. A margin of safety can also be a business whose products and services will not be significantly affected by an economic downturn.

Microsoft has about $82 billion in long term debt. It is also the only US company, besides Johnson and Johnson, to have AAA bond rating. Microsoft also has about $134 billion in cash. Apple has about $97 billion in long term debt and about $244 billion in cash on hand. Both of these companies have significant margins of safety in case of a financial downturn. The question is what happens to their revenue if the economy tanks? Microsoft is no longer so dependent on its Windows software for profits but Apple still needs to come up with the better and more impressive set of smartphones and tablets every year or so.

A margin of safety issue that is appropriate to how to spot an overpriced investment is that both of the companies are in a “high cost of entry” business. This is to say; the development of patents, product lines, and internal skill sets is such that there would be an almost insurmountable cost to replicate either business. This is where Tobin’s Q ratio comes into play. To the extent that a business controls an irreplaceable niche in the tech world, they are protected against financial devastation in the event of a market correction. One of the ways to spot an overpriced investment is to use this sort of analysis or approach.